Cerberus To KKR: Eat Our Dust

It was an epic showdown between legendary buyout king Henry R. Kravis and New Age hedge fund manager Stephen A. Feinberg -- and Feinberg won. On Apr. 3, General Motors Corp. (GM
) announced that it would get about $14 billion over the next three years for selling a 51% stake of its highly profitable GMAC finance division to a group led by Feinberg's firm, Cerberus Capital Management LP.

Ever since, Wall Street has been buzzing over how the 46-year-old Feinberg snapped up a huge financial-services company for little more than its book value from Kravis, age 62. Kravis may someday look wise for having turned his back on a deal heavily laden with risk. But losing to Cerberus has to sting.

A big battle between established buyout firms such as Kohlberg Kravis Roberts & Co. and scrappier hedge fund groups like Cerberus -- named after the three-headed dog in Greek mythology that guards the gates of Hades -- has been brewing for a while. In a 2004 speech to a few hundred private-equity investors and bankers, Kravis warned that hedge funds had little experience managing companies or "creating value."

Since then, Kravis has been forced to fend off Feinberg multiple times to buy companies. In 2005, a KKR group beat out Cerberus for troubled retailer Toys 'R' Us Inc. by paying $6.6 billion for it. In January, a Cerberus group picked up the grocery chain Alberston's Inc. (ABS
) that KKR had been eyeing.

The next round came when GM sold most of GMAC's commercial mortgage unit to a group led by KKR on Mar. 23. (GMAC sells auto financing, mortgages, and insurance.) Little more than a week later, Cerberus beat out KKR for the big kahuna -- a majority stake in GMAC itself. That means Cerberus is indirectly a part-owner of KKR's commercial mortgage business. Kravis may have to deal with Feinberg whether he likes it or not.

"APPLES TO ELEPHANTS"

For Feinberg, snagging GMAC means much more than besting Kravis. He hopes the deal will propel Cerberus from a behind-the-scenes operator into a well-respected financial-services company. That's a big leap for a private investment firm that started with a grubstake of $10 million in 1992. Cerberus now manages $18 billion in assets, excluding the GMAC deal (BW -- Oct. 3).

Feinberg won the day in part by accepting risks that every major bank and marquee buyout firm that GM approached about the deal turned down. For starters, Cerberus will take control of more than $300 billion of leases, loans, mortgages, and insurance policies. The auto-related leases and loans could be a drag if GM's problems get worse. Feinberg also agreed to invest GMAC's aftertax earnings and dividends for five years, and not to break GMAC apart without GM's consent. In addition, he promised to continue to support loans to dealers and leases to buyers of GM autos for 10 years.

During that time, GM will have the option to buy GMAC back under certain conditions, including GM becoming an investment-grade company. The buyback rights "required a lot of flexibility on the part of Cerberus, and [resulted] in a lesser initial sales price," says GM CEO G. Richard Wagoner. "We wanted the most cash we could get, but flexibility was more important." Adds Standard & Poor's credit analyst Robert Schulz, who reviewed the deal: "There's still plenty of remaining risk."

The deal is so complex that even people who saw the final bids submitted by KKR and Cerberus disagree over how much was offered. Some say KKR was willing to pay a higher initial price, but Cerberus would pay more in the long run by reinvesting in GMAC and making other commitments. Others dispute that. "The offers were so different that they were not apples to oranges, they were apples to elephants," says one adviser who asked not to be named. Nevertheless, Wall Street is agog over the unprecedented $6 billion check that Cerberus and some of its limited partners are writing.

Neither KKR nor Cerberus was GM's first choice when it announced last October that it was going to sell a majority stake of the division to a "strategic partner," people close to the deal say. Rating agencies Standard & Poor's and Moody's Investors Service (MCO
) had made clear to GM that GMAC's credit rating could be separated from the struggling auto maker's only if it sold a majority stake of the division to a large bank. GM, whose own rating had sunk to junk level, badly wanted GMAC to get its own, higher, rating: GMAC's contributions to GM's earnings were shrinking, in part because of rising borrowing costs. In 2005, it contributed $2.8 billion to GM's earnings, down from $2.9 billion in 2004.

Although many banks looked at the deal, none were interested in swallowing GMAC alone -- it was too risky. When GM began to consider joint bids by banks and buyout firms in December, some of GM's advisers thought KKR was a shoo-in because the firm was already in the process of buying a big chunk of GMAC's commercial mortgage business. One person close to GM's board denies this was the case.

Almost two months later, GM's advisers presented what were expected to be the final two bids for majority stakes in GMAC to the board. KKR, with Wachovia Corp. (WB
), had submitted a highly conditional letter and term sheet. By contrast, Cerberus, which had code-named the GMAC deal "Hercules," had marked up every section of a purchase agreement and had spent tens of millions of dollars for roughly 300 people to pore over 8,000 GMAC files and other documents.

KKR still wouldn't let up. In late February it rounded up a group of blue-chip partners that might eventually get GMAC the investment-grade rating it wanted -- General Electric (GE
), Wachovia, Merrill Lynch (MER
), and the Bank of Nova Scotia (BNS
). But that didn't deter Cerberus. Not long after, Feinberg, notorious for his hatred of traveling far from his Park Avenue office, met Wagoner in Detroit in mid-March. His partner, Citigroup CEO Charles O. Prince III, also went to visit Wagoner on Mar. 23 to personally vouch for Feinberg.

Feinberg badly wanted the deal. Just weeks before the board met to make its final decision on Mar. 26, one Cerberus partner decided not to contribute $1.5 billion to the deal. Feinberg impressed the carmaker by saying he would not cut the price -- and his firm would make up the difference.

By the time KKR tried to bust its way back in, "it was almost no contest," says someone close to the board. "I don't think there is any other financial institution in the world that would have done this deal." That's a fact -- for better or for worse.

By Emily Thornton, with David Welch in Detroit, Mara Der Hovanesian and Diane Brady in New York, and Dean Foust in Atlanta